What Not To Do
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Let’s get right into it!
What Not To Do
I’ve made SO many mistakes in my investing career. Like, an unbelievable amount. The allure of a potential 100 bagger will turn off your brain. And the pain of changing your mind when a stock is down 50% will cause you to rationalize evidence that is, if you’re honest, contradictory to your original thesis. But this is the game. The pendulum of fear and greed in single stock picking can be mind-bending at times. So this week’s post is my attempt to share some of the same mistakes I’ve made. Here are the three main ones I could come up with:
Don’t invest in unprofitable companies
I’ve said this before but here are some more details around this. People mean very different things when they say this. I mean “cash from operations is negative”. I’m willing to invest in a company that is GAAP EBIT or net income negative if there is some stock-based compensation or some weird warrant deal or even in the very rare case, a company that is free cash flow negative because they are investing so heavily in capex. If a company has negative cash from operations that means they don’t have true economic returns yet and they don’t have helpful working capital conditions (like negative working capital or deferred revenue) that can cut down on the need to fundraise.
There are always exceptions to the rule but I’ve found that if you simply wait to get confirmation that the business model actually works (i.e. at least one dollar of positive free cash flow), then, on a risk-adjusted basis, the investment actually can be better even if you give up the first 2-4x. Put another way, if you find a cash-burner at $10/share, once it reaches free cash flow positive status, it could be a better risk-adjusted investment at $30/share, for instance.
It is very helpful to look at incremental margins when doing this exercise. If the incremental margins are already positive, then that reduces the risk. This just means that if the company is losing fewer absolute dollars on more revenue dollars, there is real progress being made. For example, if the company loses $30 million in one year and then $20 million the next, on $30 million more dollars of revenue, the incremental margins could already be >30% (+10/30) even though absolute margins are around -15% (-20/130).
If a company is free cash flow positive but GAAP unprofitable, the cause is usually stock-based comp. If it’s GAAP profitable but free cash flow negative, it’s usually capex. In this case, what I like to do is take cash from operations and subtract depreciation to get a rough owners earnings estimate. Sometimes a company is spending a ton on capex to ramp up a factory or something but their actual maintenance capex – the amount they need to spend to keep their current revenue base and not lose competitive positioning – may be lower. Using depreciation as a proxy for maintenance capex is not always correct but it makes sense considering that is the amount that the accountants say the PPE base is degrading every year. So, logically, they would need to replace that wear-and-tear (i.e. maintenance). If a company is GAAP profitable but cash from operations negative, that usually means a working capital problem. And most of these problems boil down to inventory build or accounts receivable collections. Both of these problems usually stem from customer concentration and bargaining power. For instance, big customers know they have leverage so they won’t pay you quickly. It’s usually not as much of a worry if inventory is building, but it’s terrible when a company orders too much and then demand dries up. That leads to inventory write-downs which are never fun. But watching receivables is important because if you are recognizing revenue but can’t collect your cash on time, that shows that your product may not be mission critical. Because if you really had bargaining power, your customers would be fearful that you’d cut them off for their late payment habits.
It is important to normalize working capital changes based on growth because it can be difficult for a physical goods company to grow quickly without big changes in working capital. But if the growth in inventory and receivables is significantly beyond the dollar amounts of revenue increase, then there is a serious problem.
If the company is GAAP unprofitable and cash from operations unprofitable, and incremental margins are not exciting, then you probably don’t have a real business. If you passed on every single one of these opportunities, this is probably the single, easiest way to increase your investing batting average. Sure, you may miss a huge winner, but this is what I’ve found from looking at thousands of companies.
